Difference Between Absolute and Relative PPP Quiz

Absolute PPP is the strictest form of the PPP theory. It claims that the exchange rate between two currencies should precisely equal the ratio of the price of an identical basket of goods in each country. For example, if the same basket costs 500 pesos in Mexico and 25 dollars in the US, absolute PPP predicts an exchange rate of 20 pesos per dollar. This condition requires fully competitive markets, no trade barriers, and identical goods.

The answer is False. Absolute PPP rarely holds precisely in practice. Trade barriers, transportation costs, tariffs, taxes, and the large share of non-tradable goods in most economies prevent prices from fully equalizing across borders. Additionally, quality differences, consumer preferences, and measurement issues in constructing comparable price baskets mean that the strict price equality predicted by absolute PPP is an idealized condition rather than an observed outcome.

Relative PPP is a more practical version of the theory. Instead of requiring identical price levels, it predicts that the rate of change of the exchange rate should equal the difference in inflation rates between two countries. If Country A has 5 percent inflation and Country B has 2 percent, Country A's currency should depreciate by approximately 3 percent relative to Country B's currency to preserve relative purchasing power over time.

Absolute and relative PPP differ in what they require. Absolute PPP requires full price equalization, which is very demanding. Relative PPP only requires that exchange rate movements track inflation differentials, which is a weaker and more testable claim. Because relative PPP focuses on changes rather than levels, it is more consistent with real-world data over medium to long time horizons. Both forms predicting identical outcomes at every point is incorrect, as they have different conditions and empirical records.

The answer is True. Unlike absolute PPP, which requires prices to be equal across borders, relative PPP only requires that exchange rates change to reflect inflation differences. Two countries can have permanently different price levels while still satisfying relative PPP if their exchange rate moves proportionally to the inflation rate gap. This makes relative PPP a less restrictive and more empirically supported version of the purchasing power parity framework.

Relative PPP predicts that the currency of the higher-inflation country depreciates by approximately the inflation differential. With Country X at 8 percent inflation and Country Y at 3 percent, the differential is 5 percent. Country X's currency should therefore depreciate by approximately 5 percent relative to Country Y's currency to keep the real exchange rate between them stable. This aligns the nominal exchange rate movement with the difference in their price level changes.

Testing absolute PPP requires constructing perfectly comparable price baskets across countries, which is extremely difficult due to quality differences, consumption patterns, and data limitations. Relative PPP sidesteps these issues by focusing on changes over time. If inflation data is reasonably accurate, economists can test whether inflation differentials are associated with corresponding exchange rate movements, making it a far more tractable and widely tested empirical proposition.

The answer is False. Absolute PPP does not predict identical inflation rates across countries. It predicts that exchange rates adjust to keep the price of a comparable basket of goods equal across borders. Countries can still have different inflation rates under absolute PPP as long as exchange rates move to compensate. Only if exchange rates were permanently fixed and goods were perfectly tradable would absolute PPP require identical inflation rates.

Absolute PPP requires that goods are truly identical, that arbitrage can freely eliminate price gaps, and that markets are competitive enough to enforce price equalization. Non-tradable services actually undermine absolute PPP because they cannot be arbitraged across borders, allowing price levels to diverge. A large non-tradable sector is a key reason why absolute PPP fails in practice rather than a condition that supports it.

The Balassa-Samuelson effect is a systematic challenge to absolute PPP. It argues that productivity growth in the tradable goods sector of richer countries raises wages across the entire economy, including non-tradable services. Because wages are higher, non-tradable service prices are higher in wealthy countries. This creates a persistent and systematic pattern of higher overall price levels in rich countries, meaning that absolute PPP will overvalue their currencies relative to the actual market exchange rate.

The answer is True. Studies of relative PPP consistently find that while short-run exchange rate movements are poorly explained by inflation differentials, over periods of five years or more the relationship between inflation differences and exchange rate changes strengthens considerably. This is consistent with the view that PPP is a long-run equilibrium condition to which exchange rates gradually converge rather than a precise short-run predictor of daily or monthly currency movements.

The real exchange rate measures competitiveness by combining the nominal exchange rate with the ratio of price levels between two countries. When the real exchange rate equals one, it means that the nominal rate has fully adjusted for price differences and purchasing power is equalized. PPP holds when this condition is satisfied. When the real exchange rate deviates from one, currencies are either over or undervalued relative to their PPP equilibrium.

Absolute PPP breaks down where prices cannot equalize through arbitrage. Housing and non-tradable services like haircuts and meals show large cross-country price differences because they cannot be shipped. Subsidized domestic energy prices diverge from global market prices due to policy distortions. Identical prices for globally standardized electronics in open competitive markets would actually be consistent with the law of one price and approximate PPP, making Option D incorrect.

Relative PPP provides a clear framework for understanding long-run exchange rate trends in high-inflation economies. If an emerging market consistently runs inflation significantly above that of its trading partners, its goods gradually become less competitive internationally. The exchange rate depreciates to offset this loss of competitiveness. Over decades, the accumulated inflation differential explains the cumulative weakening of the currency, which is precisely the relationship that relative PPP predicts.

The answer is False. Relative PPP directly contradicts this. If a country consistently has higher inflation than its trading partners, maintaining a fixed exchange rate means that its goods become progressively more expensive relative to foreign goods. Competitiveness erodes, the current account deteriorates, and reserves come under pressure. Relative PPP predicts that the exchange rate must eventually depreciate to reflect the accumulated inflation differential, making a permanently fixed rate unsustainable under persistent inflation divergence.